Forex: Mellon FX Daily - European Edition

Key Points
• EUR-USD rises in early European trading, but some USD support should be forthcoming.
• USD prospects will depend in part on oil price developments and any messages from the Fed.
• Chicago Fed’s Moskow speaks later today.
• German ind prod, BoC policy outcome and Fed’s Beige Book also due.

Market Outlook
In Asia, EUR-USD survived a test of yesterday’s low of 1.2442 before bouncing back ahead of the European open. Indeed, the move above 1.2515 early in the European session is a positive signal, although 1.2545 will also need to be taken out to reestablish the recent positive bias. More likely perhaps is a move below 1.2440 and a test of 1.2400, although much will depend upon how oil prices develop today and any indications from the Fed on what they are thinking about policy.

The market remains uncertain about near-term growth prospects, but the sense of panic that was prevalent last week has clearly subsided along with oil and gasoline prices. Sentiment will remain responsive to movements in energy prices and for this reason alone FX market participants will proceed with some caution, but as it currently stands there is every chance of the USD stabilising further today.

With energy price strength abating somewhat the Fed is in a better position to argue that tightening should continue, although the risk of them skipping a hike at the September 20 meeting remains in place given the scale of the hurricane devastation. More on this subject should be taken from a speech by the Chicago Fed’s Moskow today (see below). Any firm views on the post-hurricane scenario could influence markets either way, but as we have mentioned recently, even if rates are left unchanged on September 20 the Fed will be keen on advancing the message of underlying strength in economic activity and the likely resumption in tightening thereafter. On this basis, the recent damage to short-term rate expectations is probably complete, although again such expectations will remain sensitive to energy prices.

The RBA left rates unchanged last night, although a strong Q2 GDP performance has supported the AUD. However, it is unlikely to advance through the 0.7700-50 area in the shortterm. Tonight’s employment data will be significant for how things develop. Below 0.7645 is needed to undermine the momentum behind the latest upmove.

Day AheadEurozone – German manufacturing output will be closely watched after the strong orders data yesterday. Orders had been strong in prior months and a pullback was generally= expected yesterday, so it will be interesting to see whether output exhibits a similar pattern.

US – Q2 productivity and unit labour costs are out, while the Beige Book is also released and Chicago Fed president Moskow is scheduled to speak about the economy. There is unlikely to be much in the way of market impact from the productivity data – it is a second estimate – while the Beige Book is likely to have been prepared before the onset of the hurricane and may do little to influence expectations on Fed policy. The speech by Moskow is likely to be the most interesting as it could be used as a vehicle for expressing Fed thinking on current issues.

the BoC are likely to raise rates by 25bp, although key for the market reaction will be what they signal about the future – specifically how they deal with the issue of higher energy prices. Will they focus on the negative consequences for the Canadian consumer or the boost because of Canada’s role as a net oil exporter? Some caution is likely, although overall a signal of further rate rises does seem likely. If this occurs a test below 1.1800 looks likely on USD-CAD, although it is not clear whether sufficient momentum will be generated to take out the November 2004 low at 1.1725. This may hold out a little longer. Any official observations about the exchange rate itself will also be significant.

2005, Mellon Financial Corporation Note: Although obtained from sources believed by us to be reliable, Mellon Financial Corporation and its affiliates cannot guarantee the accuracy or completeness of the information upon which this report is based. This report does not purport to disclose the risks or benefits of entering into particular transactions and should not be construed as advice in any specific instance. The views in this report constitute our judgement as of this date and are subject to change without notice.
Ian Gunner 44 20 7163 5996 06.40 EDT Monday May 31 2005

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